Most people who work for a company that is offering employee benefits likely know what a 401(k) plan is: a retirement account you fund with pre-tax dollars that grows tax-free until reaching retirement age. But you might be wondering, “Why is it called 401(k)?”
What you’ll learn
What you’ll learn
Key takeaways
- The term “401(k)” comes from the US Internal Revenue Code, which sets special rules for this kind of retirement plan tax benefit.
- Several 401(k) options exist, including traditional 401(k), Roth 401(k), and safe harbor 401(k).
- 401(k) plans encourage savings by offering tax advantages and flexible investment choices.
- Over time, laws and trends have shifted how 401(k) plans work, with modern features like auto-enrollment and broader investment selections.
Below, we’ll dive into how the 401(k) plan came to be and where its unique name came from. We’ll also explore the various types of 401(k) plans for businesses, and how they have evolved.
Origins of the 401(k) term
The story of how the 401(k) name came to be is fairly straightforward: an Internal Revenue Service (IRS) code.
The Internal Revenue Code
So, why is it called a 401(k) plan, and how does it work? The short answer is that the name stems from Section 401(k) of the US tax code, which outlines rules for certain tax-advantaged retirement accounts. Employees can save a portion of their income in these accounts and defer taxes until they withdraw the funds.
On the flip side, a Roth 401(k) allows employees to pay taxes upfront to avoid paying them later. Essentially, “401(k)” is just a nickname pointing directly to the law that makes these accounts possible. Essentially, “401(k)” is a nickname that points directly to the law making these accounts possible.
Historical context of retirement plans
Long before 401(k)s arrived, many workers depended on pensions, which are retirement plans that employers fund. However, many companies have phased out pension plans due to their cost and complexity. As pensions faded, interest grew as to other ways to help employees save for their future. Traditional individual retirement accounts (IRAs) were introduced in 1974, but employers wanted something they could offer as a part of their employee benefits package. Through this desire came the idea for what we now call the 401(k).
Introduction of Section 401(k)
Congress passed the Revenue Act of 1978, which, among other things, added a new section to the tax code: Section 401(k). Initially, the law only allowed an individual to defer a tax-free portion of their bonus or stock options, so it received little attention. However, in 1981, the IRS released new rules that allowed employees to contribute to these accounts tax-free from salary deductions, launching the modern-day 401(k) plan.
Next, let’s talk about some fund options employers have access to that they can set up in their organization.
Types of 401(k) accounts
Three types of 401(k) accounts exist, each with benefits and drawbacks. Let’s review them.
Traditional 401(k)
In a traditional 401(k), employees contribute pre-tax money from their pay. This lowers their taxable income for that year, reducing the income taxes they owe. When they withdraw funds, they pay taxes on the money at whatever their tax rate is at that time. For example, if you earn $50,000 a year and put $5,000 into your traditional 401(k), the government only taxes you on $45,000 in income that year. When you take money out during retirement, you pay taxes on the withdrawn funds based on your tax bracket at that time. The same would be true for making an early withdrawal, along with an additional tax or penalty for doing so.
Roth 401(k)
A Roth 401(k) is the reverse. You pay taxes on your contributions now, but the money you withdraw later, including potential gains, is generally tax-free (if you follow the rules). A Roth 401(k) benefits people who think they’ll be in a higher tax bracket in retirement.
Safe harbor 401(k)
In a safe harbor 401(k), employers must make certain contributions to employees’ accounts, often as a match or a nonelective contribution. As an alternative to the employer contribution, the plan is simpler to administer and automatically meets many IRS guidelines.
This is great for your business to avoid complex tests measuring whether highly paid employees save more than everyone else. It is a smart option for small or mid-sized businesses because it reduces some legal headaches and more predictably helps employees build retirement savings.
Solo 401(k)
A solo 401(k) — sometimes called a one-participant 401(k) or a self-employed 401(k) — is a retirement plan designed specifically for business owners who have no employees other than a spouse.
With this plan, you function as both the employer and the employee in your business, so you can contribute in both capacities. This unique setup allows self-employed individuals, freelancers, and independent contractors to save significantly more for retirement than they could with a standard 401(k) or a traditional IRA.
You can also use the table below to compare these different retirement savings options:
| Plan type | Tax treatment | Employer contributions | Best for |
| Traditional 401(k) | Pre-tax contributions (taxes paid upon withdrawal in retirement) | Optional (employers can choose to match) | Employees who want to lower their taxable income now |
| Roth 401(k) | Post-tax contributions (withdrawals in retirement are tax-free) | Optional (employers can choose to match) | Employees who expect to be in a higher tax bracket in retirement |
| Safe harbor 401(k) | Pre-tax or Roth options available | Mandatory (employer must make set contributions) | Businesses that want to automatically pass IRS compliance testing |
| Solo 401(k) | Pre-tax or Roth options available | Yes (owner contributes as both employer and employee) | Self-employed individuals with no employees (other than a spouse) |
Now that we have discussed some of the different 401(k) programs employers consider, let’s find out more about how savings programs have evolved over time.
The evolution of 401(k) plans
Changes in legislation
Since the early 1980s, many legislative tweaks have impacted 401(k) accounts. Congress and the IRS regularly review contribution limits, matching rules, and other details that aim to keep retirement savings plan rules fair. They also use rule changes to encourage saving.
For example, the Pension Protection Act of 2006 introduced new features including automatic enrollment. This change made it easier for employees to start saving without extra steps, making it one of the more popular benefits for SMBs. More recently, individual states have launched their own state-mandated programs, which require applicable employers to provide employees with access to a retirement savings program or savings opportunity.
Trends in employee participation
Over time, 401(k)s became many Americans’ main form of work-based retirement plans, especially as pensions declined in the private sector. Employees now have more investment choices with their 401(k) accounts, with some plans offering target-date funds or brokerage windows, helping increase participation rates. Employers often help by matching some contributions, further encouraging employee participation. It’s estimated that about 80% of eligible employees currently enroll in a 401(k) program.
Simple and valuable
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— David Mazaika, Coulomb Solutions Inc
Modern investment options
Early 401(k)s had just a few mutual funds or a company stock to invest in. Today, you’ll often find numerous 401(k) investment choices, including index funds, bonds, and even alternative assets. Some 401(k) plans remove much of the mystery of investing by offering managed accounts or robo-advisors to guide employees. These new approaches reflect how the 401(k) space always evolves to handle new laws and meet changing employee needs.
Bottom line: The lasting impact of Section 401(k)
Beyond its origins in the 1978 tax code, the 401(k) has become the standard for building a healthy financial future. What started as a small provision is now the primary way Americans save for life after their careers wrap up. Offering a retirement plan is a great way to attract talent and show your team you’re invested in their future, but setting it up can feel like a full-time job. Fortunately, OnPay’s payroll and HR software can streamline the 401(k) process. We integrate with top retirement providers to keep your benefits and payroll all in one place. Have questions? Our team is here to help!
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.